A Club Membership With Financial Benefits

Costco has a sound strategy and attracts a higher-income clientele than Wal-Mart and Target, which are more sensitive to economic factors.

Apr 3, 2014 at 11:20AM

Costco Wholesale's (NASDAQ:COST) recipe for success is simply to provide its members with low prices on a wide variety of product categories. While there are a limited number of product choices, consumers can be assured of the items' high quality. The warehouse club retailer attracts customers with higher incomes than its retail peers Target (NYSE:TGT) and Wal-Mart Stores (NYSE:WMT). This makes Costco less sensitive to factors such as higher gas prices that take a bigger bite out of lower-income consumers.

Costco's business strategy has endeared itself to its customers. Along with the annual fee that members pay, this engenders loyalty. All told, this makes Costco an investment worthy of consideration.

Room for growth
Costco has just 462 stores in the United States and 87 in Canada. This gives the company plenty of opportunity to grow its store base in North America. However, the retailer is wisely choosing a prudent course, opening between 10 and 13 stores a year domestically between fiscal 2010 and the middle of fiscal 2014. In Canada, it has opened a total of 10 stores over the same time period. Costco operates another 100 stores internationally, meaning it also has an opportunity to grow outside of North America.

In contrast, Wal-Mart's Sam's Club warehouse concept has 632 stores, the vast majority of which are in the United States. Meanwhile, privately owned BJ's has over 200 locations in 15 states. It does have some conveniences, such as accepting manufacturer coupons and a variety of credit cards, including American Express, Visa, and MasterCard. In contrast, Costco only accepts American Express. On the downside, BJ's charges for a one-day pass. In addition, on recent shopping trips, this Fool noticed Costco's stores presented a cleaner environment.

A blip in results
Upon deeper analysis, sales growth was better than the reported numbers reflect. Top-line growth was held back by lower prices on gasoline. This has nothing to do with consumers buying fewer goods in Costco stores. Excluding the impact of lower prices at the gas pumps, along with the negative impact of foreign exchange, total comps were up by 5% for its fiscal second quarter, which ended Feb. 16. Comps increased by 5% in the U.S. and 7% in the international segment.

Without adjusting for these changes, comparable-store sales were up 3% for the quarter. Breaking this out by region, that's a 4% comp increase in the United States and flat comps for the international segment.

Its bottom line was a bit disappointing. Costco's quarterly earnings came in at $1.05 per diluted share, down 15.3% from a year ago. There was a one-time tax benefit in the year-ago period, which added $0.14 per share. Excluding this, diluted earnings per share fell 4%.

Management said quarterly earnings were hurt by weaker sales and margins in certain merchandise categories, as well as in Costco's fresh foods business. In particular, the first four weeks of the quarter were weaker, as Wal-Mart, Target, and other retailers aggressively discounted goods and matched competitor prices. Investors, though, should not be overly concerned by one quarter's results.

Results for Wal-Mart's fourth quarter, which ended Jan. 31, will not thrill investors. Excluding certain items, diluted earnings per share were $1.60, down 4.2% year over year. Meanwhile, Target's quarterly earnings, also adjusted for items, fell 21.2%, to $1.30 a diluted share.

Costco generates a comforting cash flow, no matter its mediocre second-quarter results. For the first half of this fiscal year, the retailer generated $631 million in free cash flow, 8.4% higher than a year ago. This comes about despite increasing capital expenditures by 8.3%, to $1.02 billion.

Final Foolish thoughts
Costco's shares sold off over 4% in the last month in the wake of its earnings report. Granted, the shares are not cheap, with a P/E of 25. However, this may prove an attractive entry point for a company with a proven track record.

Costco stockholders can take comfort in steadily rising dividends. Since 2004, the company has increased its quarterly payout from $0.10 a share to the current $0.31. This does not include the special $7 dividend the company paid at the end of calendar 2012 in order to save its investors taxes in anticipation of a higher capital gains tax hike.

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Lawrence Rothman has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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